QE Correlation Does Not Imply QE Causation

The markets are much more sophisticated than the basic cause and effect analogies that constantly bombard investors.

The markets are much more sophisticated than the basic cause and effect analogies that constantly bombard investors. These correlations are passed off as obviously related yet they fail the most basic statistical test. Is the whole industry operating under a fundamental flaw?

The smart money doesn't buy into these correlations because fading them is how they make money. In September 2011 Bloomberg's Erik Schatzker interviewed Bridgewater's Ray Dalio who is perhaps one of the most successful fund managers. Schatzker asked about asset correlations (emphasis mine):

Schatzker: People say correlation among different asset classes is increasing, making the job of being a macro hedge fund manager harder. Is that true?

Dalio: No.... I think that there is an intrinsic characteristic that determines the returns of asset classes. So, a very simple example would be if you knew that the – if inflation was to come down by a certain amount, you multiply that times the duration of the bonds, and all things being equal it will carry over to the bond return. And so that there's a certain structure that exists in asset classes.

There is no such thing as in intrinsic classic correlation. So, the relationship between bonds and stocks, for example, could either be positively correlated or negatively correlated depending – and both of them make sense if you know what determines the pricing of the asset class.

So bonds are always logical in that way. Stocks are always logical. But if you come into a time, for example, when economic uncertainty and volatility is greater, then they'll be negatively correlated. If you're in a period of time where inflation uncertainty and volatility is greater, they will be positively correlated.

Both of those things are logical if you know how they behave; therefore, it's that understanding, not a fixed notion that there should be a correlation. That fixed notion of a correlation doesn't exist. There's no such thing as correlation. There's only the logical behavior of each of those two markets that then will determine its relationship.

I think investors are making a big mistake interpreting price action as reflective of a resolution in Europe, global central bank intervention, or improving economic growth. There is something happening under the surface that trumps the elementary cause and effect. This rally in stocks has been a multi-year squeeze in negative sentiment, and I believe it is beginning to climax.

When I wrote Trading the Wrong Playbook Bubblein June of 2012, I tried to get investors to focus not on the headlines but on what I believed to be behind the market price action:

If this market truly is just back-filling the gaps left behind by the financial crisis then making this area of support is very bullish and could point to new all time highs going into the fall.

The massive underperformance of the investment community is attributable to a wrong playbook bubble. This market cycle doesn't care about growth or discount, it cares about positioning and sentiment.

ES COT Large Speculators Net Position

After being net short for a full year, large speculators finally got long after the market had rallied 35% in their face. When the S&P (INDEXSP:.INX) e-mini futures contract (ES) crossed the previous high at 1400 specs top ticked the market as we saw a subsequent 7% correction into November. They reinitiated long positions into year end only to reduce as the rally continued into the 1500 level, and by the middle of February, were essentially net flat with the S&P at 1515. When the S&P held the 1500 level on the brief February correction, the specs piled in and quickly jammed ES into the 1550 level where stocks have vibrated for three weeks.

This week's CFTC commitment of traders report showed large speculators increased their net long position by an astounding 152,000 contracts to 256,000. This would be the longest specs have been since coming out of the 2009 low and exceeds any period in the rally between 2002 and 2007.

This change in positioning is very important because, as evidenced by the increase in volume since the beginning of the month, I believe there has been a big shift in ownership of this market from real money into levered accounts.

Market Picture

Last week the ES June contract traded 10 million shares and the average weekly volume for the month of March has been 9.27 million. The week ended 3/1 ES volume was $13.2 million. Contrast those with the average weekly volume since the November 2012 low of $6.6 million. The 4-week move from 1515 to 1550 saw volume increase 50% more than during the 14-week move from 1405 to 1515.

The ES contract closed the week ended 3/8 at 1549.50 on 9.2 million contracts, the week ended 3/15 at 1553.50 on 8.57 million contracts and last week at 1552.00 on 10 million contracts. This past week we saw three straight 20-point ranges with volume exceeding 2.5 million shares on Tuesday, a feat only accomplished five times this year. The volume weighted average price (VWAP) for the ES contract this week was 1545.90 with 65% of the volume trading between 1545 and 1550 despite a total range between 1530 and 1556. And you'll notice that the 1550 bucket saw the highest volume at 35% of the total and 8x the 1555 bucket.